Although the mutual fund sales practices rule has been on the books for almost 20 years, enforcement actions targeting violations of the rule are beginning to emerge only now as regulators become increasingly concerned about conflicts of interest.
The rule, which was adopted in May 1998, was one of the regulators’ early efforts to stamp out conflicts of interest in the fund industry that could influence financial advisors’ advice at the expense of their clients’ best interests. Yet, there has been little enforcement activity involving alleged violations of the rule’s requirements.
That’s beginning to change.
Notably, the Mutual Fund Dealers Association of Canada (MFDA) settled a case with Waterloo, Ont.-based Sun Life Financial Investment Services (Canada) Inc. in December 2017 that cited violations of the sales practices rule. That case resulted in a $1.7-million fine for Sun Life.
There are additional enforcement actions on the horizon.
However, several months are likely to elapse before these other cases are brought to a hearing, says Shaun Devlin, senior vice president, member regulation, enforcement, with the MFDA.
Details of these other cases remain under wraps until the enforcement actions are made public. However, Karen McGuinness, the MFDA’s senior vice president of member regulation, compliance, reports that the issues the self-regulatory organization’s compliance department has referred to enforcement involve alleged violations of the sales practices rule. These cases stem from integrated dealers operating compensation or incentives programs that favour in-house mutual funds over the third-party mutual funds the firms also offer.
This is the type of fundamental conflict the sales rule was designed to eliminate by guarding against incentives structures and other industry practices that could damage advisors’ objectivity and harm clients’ interests.
In particular, the rule was crafted to tackle some of the more troubling practices that were prevalent at the time, such as mutual fund sales contests, lavish industry conferences in exotic locales and compensation structures that explicitly reward the sales of certain funds over others. All of these practices could skew the advice clients receive, based on incentives offered to advisors.
The MFDA’s case against Sun Life highlights a couple of ways in which the central objective of the sales rule can be violated – both through firmwide incentives and in the activities of specific branches that reward advisors for selling proprietary funds rather than third-party products.
In the Sun Life case, the MFDA found that the firm operated a couple of long-standing incentives programs that factored in only sales of proprietary funds – namely, funds from affiliates Sun Life Global Investments (Canada) Inc. (SLGI) and CI Investments Inc. (CI). According to the settlement, those programs were established in 1989 – before the sales practices rule took effect. Yet, Sun Life failed to re-evaluate these programs to ensure that they complied with the MFDA’s rule.
Instead, these programs “inadvertently created incentives for advisors to distribute mutual funds offered by CI and SLGI rather than mutual funds offered by third parties,” the settlement states.
Sun Life’s programs have been revised since to reward advisors for their sales of proprietary and third-party funds alike, the settlement document notes.
In addition to Sun Life’s firmwide programs, the MFDA also found that a handful of Sun Life branches (two in each of Manitoba, Ontario and Saskatchewan) also operated incentives programs that rewarded advisors, in part, for sales of Sun Life mutual funds with non-cash prizes, such as tickets to sporting events and trips.
Unlike the long-running incentives programs that were established before the MFDA’s sales rule took effect, these branch-sponsored contests were much more recent phenomena – operating between January 2016 and May 2017.
This is an issue that may be catching some firms by surprise, McGuinness says: “[Firms] know what head office is doing with compensation practices, but knowing when branch managers decide to take matters into their own hands can be difficult.”
The MFDA reports that it uncovered these problematic sales incentives programs as part of a targeted compliance review of industry compensation programs, carried out in 2016 in concert with provincial regulators and the Investment Industry Regulatory Organization of Canada. The review also uncovered the other instances of alleged sales rule violations now working their way through the enforcement process at the MFDA.
Although the common issue in each of these cases is compensation structures that favour in-house funds over third-party funds, the specific practices that caught regulators’ attention varies from firm to firm, McGuinness says.
Indeed, the MFDA’s report on the review that uncovered these issues notes that the firms involved had “multi-dimensional compensation structures” featuring elements that favoured proprietary funds – such as bonuses or additional commissions that are paid only for in-house funds – along with rewards and retirement programs that are structured in a way that creates incentives that favour proprietary funds. In some cases, the firms involved began selling third-party funds only recently, but failed to rejig their existing incentives structures to level the playing field for in-house and third-party funds.
In addition, regulators are beginning to enforce violations of other aspects of the sales practices rule. For example, in the Sun Life case, the MFDA found that the firm hosted several conferences in 2015 and 2016 that didn’t comply with the MFDA’s requirements to the extent to which fund companies can finance the cost of these events.
Regulators have been concerned about compliance with the requirements for providing industry conferences for a couple of years. In 2016, the Ontario Securities Commission (OSC) published guidance on complying with specific requirements involving conference expenses. The OSC’s first enforcement action involving alleged violations of the sales practices rule, brought forth last year, featured alleged violations involving conferences.
That case, brought against Toronto-based Sentry Investments Inc., included allegations that the firm hosted a conference in Beverly Hills, Calif., as well as provided excessive gifts to advisors – such as tickets to the Formula 1 race in Montreal – that also violate the sales rule.
This recent regulatory attention to industry conflicts of interest raises the question of whether the sales rule should be broadened to cover a wider range of products beyond mutual funds. Indeed, the MFDA reports that its review uncovered sales practices that would be prohibited if the products involved were mutual funds.
Yet, at this point, dealers technically may not be offside when they engage in practices that would be prohibited in the mutual fund world, such as holding sales contests for other types of products.
This dichotomy raises concerns that as mutual fund dealers expand their businesses beyond the traditional function of advising on and selling mutual funds, the rules that govern conflicts of interest may have to be extended to other products and business arrangements.